Banks Pounded After Lawsuit, Economy Further Imperiled

Major bank stocks are trading down far more sharply than the broader markets.

Bank of America and Citi Group stock has suffered double digit losses on a percentage basis: As of the time of this writing, BofA is down 16 percent and Citi is off 14 percent, while the DJIA is trading down only 4 percent.

The proximate cause of BofA's huge sell off would seem to be investor fear of mortgage putback exposure. (Mortgage Putback exposure, which John Carney and I wrote about earlier this year , is the risk that investors may sue banks for losses on mortgage backed securities, on the grounds that the banks provided investors with false or misleading information on the underlying value of the mortgages those securities contained.)

Specifically, the sell-off of today's biggest loser of the majors, Bank of America, may be driven by news of AIG filing a $10 billion law suit against BofA.

According to the Wall Street Journal, the AIG suit is alleging "massive fraud" by BofA in its creation and sale of securities involving "hundreds of thousands of defective mortgages."

(The suit also covers mortgage securities created by Countrywide Financial, which is now owned by BofA.) The New York Timesis reporting that Bank of America has responded via email: "A.I.G. recklessly chased high yields and profits throughout the mortgage and structured finance markets. A.I.G. is the very definition of an informed, seasoned investor, with losses solely attributable to its own excesses and errors. We reject A.I.G.'s assertions and allegations."

This is more than a He Said / She Said story over which institution acted more recklessly during the height of the bull market—the insurance giant who recklessly chased another hit off the high yield crack pipe or the bank pusher who cooked up the securitization rock in the first place.

The story matters most for this reason: As the US economy approaches stall speed—banks become progressively less willing to lend, because their management's primary concern becomes protecting their own balance sheet, not taking additional risk through putting new capital to work.

When bank stocks sell off sharply, their Tier 1 Capital collapses, which means their core financial strength takes a nosedive. And that's not a position any bank CEO wants to be in—especially with the increasing prospect of a nasty double dip ahead.

Worst of all: When banks fear lending it can rapidly create a vicious downward spiral for the broader economy: The cliché about banks being the economic heart of the country is true—without capital being pumped throughout the body politic, the economy becomes far more likely to deteriorate further.

In short, the AIG lawsuit against Bank of America could not have come at a worse time.